Insolvent Foreign Subsidiaries

Jasper L. Cummings, Jr.

International Tax -
1/15/2012

Overview

The Internal Revenue Service’s Generic Legal Advice Memorandum AM2011-003, dated August 18, 2011, is one of the most talked about internal IRS opinions in recent years.[1] This so-called GLAM addresses the check-the-box liquidation of an insolvent foreign corporation and its reformation as an insolvent partnership, owing a liability to its principal partner. The guidance was issued by the National Office of Chief Counsel (specifically, its Passthroughs and Special Industries, or PSI, division) to an Area Counsel in the IRS’s Large Business & International Division, which audits retailers among others.The GLAM is understood to be a collaborative effort of at least five divisions of Chief Counsel, including the Corporate, International, Financial Institutions and Products (FIP), and Income Tax and Accounting (IT&A) Divisions. PSI, however, had the primary responsibility and would have ultimately controlled the conclusion, absent intervention by the Chief Counsel himself.

The GLAM builds on Rev. Rul. 2003-125, 2003-2 C.B. 1243, which addressed the check-the-box liquidation of a domestic corporation’s insolvent foreign subsidiary that continued to operate its business as a disregarded entity; the insolvency similarly was caused by a liability to the parent. The GLAM’s facts differ from the revenue ruling only in that a foreign affiliate of parent owns a minority interest in the subsidiary, and so the entity continued as a partnership under the check-the-box fiction. Whereas the revenue ruling held the parent could deduct an ordinary loss for a bad debt under section 166(a) of the Internal Revenue Code,[2] the GLAM denies the bad debt loss solely because the business continues as a partnership that owes the liability.

Denial of the creditor/shareholder’s bad debt loss recognition is one reason for interest in the GLAM. The other is its Crane/Tuftsbasis analysis,[3] which gives the former shareholders basis in property equal to the entire amount of the corporate liabilities they are deemed to assume, even though the liabilities exceed the value of the property.

This article demonstrates that the bad debt loss denial is wrong and argues that affected taxpayers should disagree with the GLAM. The Crane/Tufts conclusion is also wrong, but perhaps more understandable. The GLAM’s results are limited to the partnership cases and could be avoided by eliminating other owners of the foreign entity.[4]

The GLAM

A. Situation 1 of the GLAM

There is no easy way to understand this GLAM without digesting the numbers it uses in its Situation 1, in which the foreign corporate subsidiary’s debt is owed to the domestic corporate parent:

Situation 1: X (domestic) owns all of Y (foreign) and 80% (basis of $100) of Z (foreign). Y owns the other 20% of Z (basis of $30). Z owns property worth $100 (basis of $120); Z owes $110 to X (the GLAM does not state that the debt is secured by the Z assets, or whether it is recourse or nonrecourse); Z is insolvent. Z checks the box and thereby is deemed to liquidate as a corporation and to be recreated as a partnership owned by X and Y. Z continues to operate its business unchanged; indeed, it continues as a corporation for foreign local law purposes. The IRS wants to know how much, when, and what character of deduction for losses on stock and debt X and Y can claim as a result of Z’s deemed liquidation (X hopes for a $110 ordinary loss, and Y hopes for a $30 capital loss). Also, because Z reforms under the check the box fiction as a partnership owned by X and Y, the parties are interested in basis: what is the basis of the partners in the new partnership interests and what is the partnership’s basis in its assets?

The GLAM is based primarily on Treas. Reg. § 301.7701-3(g)(1) (ii), which was drafted by the Chief Counsel’s PS&I and International divisions:[5]

If an eligible entity classified as an association elects under paragraph (c)(1)(i) of this section to be classified as a partnership, the following is deemed to occur: The association distributes all of its assets and liabilities to its shareholders in liquidation of the association, and immediately thereafter, the shareholders contribute all of the distributed assets and liabilities to a newly formed partnership.

The GLAM concludes:

The shareholders of Z can deduct their basis in the stock of Z as losses under section 165(g)(1), meaning deductions of $100 (which may be ordinary loss with respect to X under section 165(g)(3)) and $30 (which will be capital loss with respect to Y); this is consistent with prior guidance. This conclusion is made even though the shareholders engage in a property for property exchange: The property they give up is worth nothing because the property they receive is subject to liabilities in excess of value.

The shareholders are deemed to buy the corporate property in exchange for their proportionate assumptions of the corporate recourse liabilities and receipt of property subject to nonrecourse liabilities (meaning X assumes or takes subject to 80 percent of the liabilities to itself).

The shareholders obtain a combined basis of $110 in property worth $100. The GLAM only partly explains this conclusion. To the extent the liability is recourse, the assumption of personal liability that the GLAM interprets the regulation to require clearly creates a basis in the property equal to the debt. To the extent the liability is nonrecourse, however, normally the Estate of Franklin/Pleasant Summit analysis would not allow the basis to exceed the value of the property securing the liability. Section 334 does not determine the basis because, according to the GLAM, the entire liquidation regime of subchapter C is inapplicable because no net value is distributed to the shareholders even though actual ownership of property is transferred.

The new partnership obtains a basis in its property of $110.

The new partners obtain basis in their partnership interests of $108 and $2, respectively, determined under sections 722 and 752, as follows: $110 combined asset basis ($88 and $22), reduced by $100 upon the deemed distribution caused by the liability assumption by Z,[6] to $10 ($8 and $2), increased by $100 because of partner X’s deemed liability assumption, totaling $110 ($108 and $2).[7] The GLAM does not bifurcate the creation of the partnership into a “sale” of the property for a liability assumption and the distribution of a valueless partnership interest; it treats the entire transaction as subject to subchapter K, even though the partnership created is instantly under water. [8]

X remains a creditor of the new partnership, presumably with its original $110 basis in a receivable (although the GLAM does not specifically state this basis) from the partnership worth $100, which is the same receivable X started with.

B. Economics

Tax folk like to test the economics of a transaction to determine whether the tax outcome conforms to the economics. The GLAM passes this test if you make the noneconomic assumptions (1) that the creditor would not have been paid first in the liquidation, (2) that X would have assumed a liability to itself, and (3) that anyone would assume recourse liability in excess of value of property received. The economic analysis looks like this:

Just before the box was checked on Z, X had invested $210 in Z ($100 in stock and $110 in a loan) and Y had invested $30.

Z has gross value of $100, all of which would go to X as the creditor upon an actual liquidation of Z; therefore, X’s economic loss is $110 ($100 stock loss and $10 loan loss), and Y’s economic loss is $30.[10]

The GLAM allows X to deduct a $100 loss, reflecting only its equity investment, apparently to retain its $110 basis in the loan, and to obtain a $108 basis in the equity of the partnership, while the minority partner obtains a basis of $2 in its interest in the partnership.

Therefore, the tax treatment of subsequent events should allow an additional $10 bad debt loss to X and no other tax consequences to the parties, in order for the tax consequences to match up with the economics, assuming no facts change. This works out as follows if Z sells its property to an unrelated buyer for $100 cash, free of the debt, and pays the $100 to X in discharge of the debt of $110 and Z is dissolved:

Z recognizes a $10 loss on the sale.

But the loss cannot be deducted by the partners because they have no remaining basis. First, their interest basis must be adjusted for the liability reduction under section 752 by $110, assuming the section 752(c) asset value limit does not apply.[11]

This adjustment leaves both partners with a zero basis in the partnership interest. Z is discharged of $10 of debt without payment, but is not made solvent and so the partners do not recognize any COD income or increase their basis therefor.[12]

Therefore, there is no partner gain or loss.

X as creditor recognizes a $10 bad debt loss. Thus, the GLAM’s conclusions “work,” in that they limit the tax loss recognition to the economic loss, but they delay X’s loan loss deduction. The numerical tax consequences of the GLAM are summarized in a table in the Appendix.

C. Alternate Constructs

Domestic parent corporations that were (or are) owed money by their insolvent foreign subsidiaries that have checked the box and become partnerships should consider the second of these two alternative arguments for why they should be allowed a bad debt loss on checking the box.

1. No Extinguishment but Real Economics

Without changing the GLAM’s call that the liability to X was not extinguished in the corporate liquidation, the GLAM could still have reached a more realistic and satisfying conclusion on the Crane/Tufts issue, by reasoning, as follows:

As to recourse liabilities: The shareholders would not agree to assume personal liability for recourse debt in excess of the value of property received that could be applied by the creditor to the payment of the debt.

But the corporation could not dissolve and give its assets to its shareholders under state law without either paying or “providing for” the payment of its liabilities.[13] Therefore, to the extent the corporate liabilities were recourse liabilities, the corporation could have avoided liquidating its assets and applying the proceeds to payment of its debts only by “providing for” the excess $10 recourse liability to be paid by someone else, and the only possible substitute debtor is the partnership, which in fact does owe the debt after the deemed liquidation. Thus, the shareholders should be deemed to assume $100 of recourse liability and receive all of the property, and then the partnership would first assume $10 and then $100 of liability and receive all of the property from the shareholders. Deeming such a temporary bifurcation of the liability should not cause a “significant modification,” triggering discharge and reissuance of the obligation.[14] Hence, the treatment of a recourse liability as riding through the deemed events can be preserved by this alternate construct. The Chief Counsel might have been deterred from this approach because it appears to violate the construct of the regulation that the corporation liabilities are deemed “distributed to” the shareholders.[15] As subsequently discussed, that is an unfortunately ambiguous concept, because (1) liabilities are not “distributed” (either property ownership passes subject to a secured debt or a person actually assumes a liability; the transfer of recourse liability cannot be accomplished without the transferee’s agreement, at least to the extent the property received by the transferee is worth less than the recourse liability); and (2) it is fair to assume that the regulation did not contemplate under water property (we know it did not contemplate liability owed to a shareholder, because that gap required the GLAM to be issued). Therefore, the GLAM couldreasonably have construed the regulation as suggested here in the absence of direct guidance in the regulation.

The partnership, in contrast to the shareholders, conceivably would have been willing to assume all of a $110 recourse liability because, in contrast to the shareholders, the excess recourse liability could not be collected from the partnership’s other property because it owned no other property, unless and until its property increase in value by appreciation or earnings.

Therefore, the suggested treatment of recourse liability would limit the property basis of X and Y to $100 (the recourse liability they assumed in the purchase); their starting partnership interest basis also would be $100; it would decrease by the partnership assumption of $100 in recourse liabilities to zero; it would increase by their assumption of partnership liabilities to $100, because the extra $10 of partnership liabilities would be Treas. Reg. § 1.752-7 liabilities that do not count as liabilities for section 752 purposes (because the $10 did not create basis in any property).[16]

As to nonrecourse liabilities: The shareholders conceivably would have taken ownership of corporate property subject to nonrecourse liabilities in excess of value because the excess debt could not be collected from their other property.

Under the principle of Estate of Franklin/Pleasant Summit, however, the shareholder basis in the property should be limited to $100.[17]

Their partnership interest basis would start at $100, be reduced for $100 liability assumption by the partnership (the extra $10 of liability is a § 1.752-7 liability), and then be increased by the same $100 of liability the partners are deemed to assume, to $100.

When the partnership sells its property free of debt for $100 and pays its creditors, whether recourse or nonrecourse, the partnership recognizes no gain or loss, recognizes no discharge of indebtedness income, and the reduction of the partners’ shares of the partnership liabilities by $100 leaves their partnership basis at zero and they recognize no gain or loss on their partnership investment.X, as creditor, has a $110 basis in its debt claim, which is satisfied for $100, and X recognizes $10 loss.

Why did not the GLAM choose this alternative? It delays the bad debt loss, just as the solution chosen by the GLAM. One possibility is that the Chief Counsel did not want to have to parse through the different treatment of recourse and nonrecourse liabilities, including particularly splitting the recourse liability assumption as previously suggested. Another possibility is that it would have required the Chief Counsel to take a position on the Estate of Franklin/Pleasant Summit issue, which he probably did not want to do.

2. Extinguishment

There is an even better alternate construct for taxpayers that also “works.” It is better for taxpayers because it allows the bad debt loss; and it works for the tax system because it does not rely on anyone’s assuming the liability of Z to X; rather, the liability is extinguished, which is what would occur in a real life corporate liquidation into a shareholder/creditor.

Upon an extinguishment, X would recognize a $10 bad debt loss along with the $100 loss on its stock (and Y’s $30 loss on its stock). From this starting point, somehow two major events must be deemed to occur to explain the ending set of facts: (1) Y somehow obtains 20 percent of the interests in Z, and (2) Z owes X $110. The most logical way Z can come to owe $110 to X is to buy the property for value and then distribute an additional $10 obligation to X. X cannot “sell” the property to Z for tax purposes, however, because Z is a disregarded entity until Y obtains an interest in Z; and Y cannot obtain an interest until it obtains some property to exchange for an interest.[18]

Consequently, Z must first be formed as a partnership. This is accomplished by X selling 20 percent of the property to Y for a $20 note; Y then contributing its property to Z in exchange for assumption of the obligation to X; and finally X selling its 80 percent of the property to Z in exchange for a purchase money note for $80. At the end of these steps, Z owns the property with a basis of $100, its section 1012 cost; X holds the $100 obligation of Z with a basis of $100. X then must be deemed to receive as a distribution an additional obligation from Z for $10, which is worthless, with a basis of zero.

The factual key to this construct is the premise that Z did not “assume” or take “subject to” any liability because the original liability for $110 was extinguished and no new liability existed until Z got the property. Because the exchanges of property by both X and Y for debt of Z up to $100 meets the definition of a disguised sale, section 707(a) applies.[19] The extra $10 obligation to X must be a section 731 distribution to X of no value. The situation is akin to a note distribution by a partnership to a partner. [20] The results of this alternate construct are as follows:

Section 707(a)(2)(B) will apply to the exchanges of X’s and Y’s property (basis of $100) for Z’s $100 combined obligation, resulting in X and Y’srecognizing no gain or loss.

Z also distributes to X its obligation for $10, value of zero, basis of zero to Z, which X takes with a zero basis and does not suffer a reduction in X partnership interest basis (sections 731, 732, 733(2)).[21]

Thus, X takes a basis of $100 in the combined obligation of Z for $110.

Z takes a basis of $100 in the property.

Y’s basis in the partnership interest is zero and X’s basis is $100 because X and Y give no value for the partnership interests and X is allocated $100 of the $110 liability of Z, thereby obtaining a section 752 basis increase. X will not be allocated the extra $10 of Z liability because that is a § 1.752-7 liability (because it did not create basis in Z’s assets).[22]

If Z sells the property to an unrelated buyer for $100 free of the liability, pays the $100 to X and the debt is discharged, and Z dissolves, the results are, as follows:

Z does not recognize any gain or loss on the sale, or on the discharge of $10 of indebtedness, because it is not made solvent.

X’s basis in its partnership interest reduces by $100 to zero be-cause all of the Z debt is eliminated.

X recognizes no bad debt loss because X’s basis was $100 and X received $100.

This alternate construct is intuitively correct because the creation of the partnership liability feels like a payment for the property in a purchase, and conveniently section 707(a) so provides.[23] If section 707(a) is not applied, then a highly unrealistic and complex set of results arises.[24]

The numerical tax consequences of the alternate construct are summarized in a chart in the Appendix.

The GLAM Reasoning

The key tax construct that allowed the GLAM to reach its conclusions is treating the debt owed by Z to X as remaining in place throughout the steps as a $110 loan by X that is first assumed in part by X (to itself) and then assumed by the partnership. This construct prevented X’s recognition of a loss with respect to its loan to the dissolved corporation Z. The GLAM justified the construct, as follows:

The regulation states: “The association distributes all of its assets and liabilities to its shareholders in liquidation of the association, and immediately thereafter, the shareholders contribute all of the distributed assets and liabilities to a newly formed partnership.”[25]

The GLAM characterizes the quoted regulation, as follows: “Under § 301.7701-3(g)(1)(ii), Z is deemed to distribute its assets and liabilities to X and Y in liquidation of Z. X and Y are deemed to receive Z’s assets in exchange for assuming or taking the assets subject to Z’s liabilities, pro rata.” (Emphasis added; note that the GLAM consistently refuses to distinguish between recourse and nonrecourse debt.)

The GLAM then justifies the characterization of the regulation by stating:“The deemed distribution of assets will not satisfy, in whole or in part, the $110 liability because under local law, Z’s $110 liability to X in Situation 1 … survives the deemed liquidation and continues in identical form as an obligation of Z, now operating in partnership form for federal tax purposes.” (Emphasis added.)

The GLAM made a key interpretative leap in the second bullet when it converted the “distribution” and “contribution” into an assumption of or taking subject to a liability. This leap interpreted the regulation to require the liability to pre-exist the assumption by the partnership in all cases, even where the liability was owed to the former shareholder, even though the former shareholders would not have assumed recourse liabilities in excess of value received, and even though the law would not normally allow basis to the shareholders in excess of value for nonrecourse liabilities. The GLAM seemingly justifies this interpretative leap because the liability continued to exist under local law.

None of the GLAM’s reasoning holds up:

Facts do not require tax construct chosen. That the entity under local law owes an identical liability to X does not preclude the occurrence of an intervening satisfaction and recreation of the debt in fact. Even without an actual satisfaction and recreation, the federal tax law cannot be precluded from applying the wellsettled rule that a shareholder/creditor of a liquidating corporation will be deemed to be paid first for its debt claim, and only then for its stock, as discussed further below.[26] Therefore, the continuation of the debt for foreign law purposes is a fact to be explained under the federal tax construct selected to govern the transaction, but it is not a fact that dictates only one possible construct, contrary to the GLAM’s claim.

Even if an assumption of recourse liabilities by the shareholders can be interpreted into the regulation, it cannot logically be extended to ignoring satisfaction of the debt to the shareholder/creditor. The GLAM chose to interpret the loose language of the regulation to mean an assumption of liabilities generally by the shareholders.[27] Perhaps this is within the realm of a reasonable interpretation of a regulation because the shareholders and the corporation could have agreed for the shareholder to assume the liabilities.[28] And the shareholder might even have assumed an obligation to itself, either as a matter of statutory requirement as in a merger,[29] or by contractual assumption.30 But the fact that such an assumption of a debt owed to the assumer can occur under local law does not control the federal tax treatment of the merger of debtor and creditor positions into one taxpayer, which uniformly has been extinguishment and that, no doubt, would be treated as an extinguishment by local law, once the assumption had occurred. After all, the fundamental reason for the regulation’s construct was to specify the order of events (the so-called assets-up approach31), not to deal with liability satisfaction.

Situation 2 of the GLAM, not previously discussed, involved corporate liability to a third party rather than to X. Again, the GLAM treats the former shareholders as assuming the full $110 of liability, thus creating $110 of basis for the property and for their partnership interests. This is incorrect, for yet a third reason that also applies to the GLAM’s reasoning on Situation 1: State law normally would not create debt assumption by shareholder or lien on property distributed to shareholder. Nothing in the regulation cited requires the introduction of the concept of liability “assumption” by the shareholder. Nothing in the regulation requires that the shareholder assume a recourse liability to anyone, much less itself. Nothing in the regulation supports placing a lien on the distributed property (the GLAM does not state that the liability at issue is secured).

In keeping with the uniform emphasis of the regulation on treating the deemed event like the actual event (as fully recognized by the GLAM),[32] the shareholders commonly would be subject only to transferee liability under local law, which normally does not create an actual assumption of the entire liability of the corporation or create a lien; rather, it only creates a right of action for an amount up to the value of the property received, but no lien.[33] That right is normally the ability to obtain a personal judgment against the transferee shareholder for an amount up to the value of the distribution received in its capacity as shareholder, with the value as measured either at the date of distribution or the date of the judgment.[34] No suchright exists at all if the shareholder exchanged value for the property by receiving it in payment of a debt claim against the corporation.

Of the three reasons explaining how the GLAM went wrong, the only one the IRS could even plausibly contest is the second. The compelling reasons the GLAM is wrong on the second point are that (1) the construct chosen exists nowhere else in the federal income tax, (2) it is contrary to longstanding law applicable to real transactions, (3) the Treasury wants the deemed transactions treated like real transactions, and (4) there is no indication in the history of the regulation that the Treasury thought about creditor claims of shareholders or intended those claims not to be extinguished. The historic treatment of such a case is discussed in the following section.

Liquidation into Creditor/Shareholder

The Congress, Treasury, IRS,and courts regard the liquidation of a corporation into its creditor shareholder as involving, first, the payment of liabilities and, second, a payment for the stock if any excess corporate property remains after discharge of the liabilities.This is supported by the following: section 337(b)(1) had to be added to the Code to ensure that the nonrecognition rule of section 337 applied to a liquidating distribution to an 80-percent shareholder in its capacity as a creditor; Treas. Reg. § 1.332-7 is the regulation that accompanies section 337(b)(1), and it states the subsidiary nonrecognition and the creditor recognition, when receiving liquidation proceeds in its capacity as creditor;35 Rev. Rul. 59-296, 1959-2 C.B. 87 (insolvent subsidiary liquidating into creditor parent treated as partial payment of debt and no payment for stock; bad debt deduction allowed);[36] Rev. Rul. 2003-125, 2003-2 CB 1243 (a shareholder creditor in a potential section 332 liquidation will receive the liquidating distribution first in its capacity as a creditor — “partial worthlessness” is possible — and nothing was received on the stock, so there was no liquidation at all);[37] H.G. Hill Stores, Inc., 44 B.T.A. 1182 (1941) (insolvent corporation owed debt to shareholder and conveyed assets to shareholder in discharge of the debt; shareholder entitled to stock loss and bad debt loss deductions;[38] in 1959, the Tax Court ruled without citation that a liquidating distribution to shareholder/creditors was first a payment of the creditor claims and then a distribution in exchange for stock); [39]and Braddock Land Co. v. Commissioner, 75 T.C. 324 (1980) (liquidating distribution to creditor shareholders treated first as payment of debts for salary and thus ordinary income to shareholder, then payment for stock).

The GLAM cites Rev. Rul. 63-107, 1963-1 C.B. 71, which did reach one unique conclusion about a deemed liquidation but did not deal with corporation to shareholder debt.[40] It was occasioned by the Treasury’s changing the entity classification regulations (i.e., adoption of the Kintner regulations[41]) in a way that caused an entity that had been treated as a corporation to be treated as a partnership, even though no action had been taken by the entity or its owners. The ruling addressed three cases: (1) the entity changed its charter so that it could continue to be treated as a corporation for tax purposes (the common case); (2) the entity did nothing; and (3) the entity changed its charter to be treated as a partnership for tax purposes after the effective date of the regulatory amendment.

The revenue ruling stated that, in case (1), the entity underwent a corporate liquidation to which section 331 applied and a partnership was created. In cases (2) and (3), the conversion would not be treated as asection 331 liquidation and the partnership would simply take over the basis of the corporation in the assets and the partners’ stock basis would become their partnership interest basis. The ruling did not address the effect of entity debt in any of the cases, either to third parties or the shareholders.[42]

The Chief Counsel and commentators viewed the holdings of Rev. Rul. 63-107 in cases (2) and (3) as being limited to a conversion resulting solely from action of the Treasury in changing the regulations and not from any action of the taxpayer.[43] When cited outside the Kintner regulation adoption era, it is apparently cited for its background statement about case (1) that the deemed liquidation of a corporation upon its change of its charter in a way that failed to satisfy the regulations’ requirements for association classification would result in a “taxable” liquidation as if an actual liquidation occurred. [44]

Indeed, the GLAM cites the ruling for this point. And yet one wonders whether the GLAM reflects a partial adoption of the approach of the revenue ruling in the cases where it said nothing happened. If so, that reliance was in error because that approach was limited to the case where the taxpayer did nothing and an entity characterization change still occurred; in the GLAM, the taxpayer checks the box.

The law is uniform in its treatment of a liquidation of a corporation into its shareholder/creditor (which the GLAM admits is deemed to occur) as first a discharge of the liability. Nothing in the check-the-box regulation changes that; and if it had tried to, to be sure, it would have made it crystal clear.

Closer Look at Issues in the GLAM

A. Liquidation of Foreign Operating Subs

A long road leads to the current treatment of corporate to branch or partnership conversions of operating subsidiaries that continue to operate.[45] Evidently, the simple fact that the subsidiary, which generally has been foreign, continues its operations unchanged, as either a branch or a partnership, does not sit well with the IRS field agents when auditing the parent’s loss recognition. Major U.S. multinationals, however, have likely enjoyed loss recognition on the liquidation of foreign subsidiaries, which the parents financed mostly through debt owed to the parent.

Obvious avenues of attack for the IRS field agent are (1) to assert that the intercompany debt is not debt but equity (and so section 332 would apply to the liquidation), or (2) that even if the debt is debt, the subsidiary is not insolvent because it has additional value as reflected in its continued operation.[46] Those are valid issues to raise on audit. They are difficult issues, however, for agents to address because they are factually messy and all of the facts are in the hands of the taxpayers. Therefore, agents tend to want a silver bullet, as in saying that the continuation of the subsidiary’s business ipso facto precludes loss recognition or that a check-the-box liquidation is not an appropriate event for loss recognition.

For the most part, the Chief Counsel has thrown cold water on the field’s efforts, up to the GLAM. The range of possible anti-tax-payer positions tried out in guidance includes:

The stock is not worthless;[47]

The check-the-box liquidation is not a section 165 worthlessness “identifiable event”;[48]

The debt is preferred stock, which makes the subsidiary solvent and section 332 applies;[49]

If making the debt preferred stock does not cause section 332 to apply because the shareholder only receives a distribution on the preferred and not on the common, then, a partial loss on the preferred does not qualify for ordinary treatment under section 165(g)(3) (and does not qualify for worthless debt treatment because it is not debt);50 and

When the corporation reforms as a partnership, the debt loss is not allowed (the GLAM).51

This series of interactions between the field and the National Office suggests a conflict between agents, who have witnessed massive tax sheltering through paper write-offs of ongoing businesses, and legal experts who know that the fateful decision to adopt the check-the-box regime has inevitable consequences that cannot be denied. Once the check-the-box genie was released, it will never reenter the box.

Liquidation into Partnership

The liquidation of a corporation and its reformation as a partnership of the shareholders has a long history in the tax law. The history shows that the situation is entirely ordinary and wholly to be expected when the corporate assets are distributed pro rata and some sort of investment or business activity continues on a joint basis. It also shows that the regulation and the GLAM are trying to combine three things that do not go together: (1) the assets up approach of an old ruling, (2) a desire to “minimize tax consequences” of the deemed liquidation, and (3) a desire to conform to the tax results of an actual liquidation. The GLAM perhaps made a choice for minimizing some tax consequences (including loss recognition) when it decided that the debt would not be extinguished, which contravenes conforming the tax results to that of an actual liquidation.

The following authorities show the uniform treatment of a corporate liquidation and partnership formation and show that the Treasury was not thinking about debt to a shareholder when it wrote Treas. Reg. § 301.7701-3( (g)(1)(ii).

Rev. Rul. 63-107, 1963-1 C.B. 71, ruled that when the taxpayer does something to cause a corporation with multiple shareholders to be treated as liquidated because of a change of its entity characteristics, it will be treated for tax purposes as a normal corporate liquidation and partnership creation (with no discussion of corporate debt to the shareholder).

LTR 9252033 involved a foreign to domestic liquidation controlled by section 332 in which the parent took carryover basis/ nonrecognition treatment and the ruling cited along with section 332 (Rev. Rul. 63-107, 1967-1 C.B. 71); the distribution to the minority shareholder was taxable.

On April 13, 1995, the Treasury issued a notice of proposed rulemaking for the check-the-box regulations. The Notice stated: “Under this approach, an election to change the classification of an organization would have the same federal tax consequences as a change in classification under current law. For example, if an organization were classified as an association taxable as a corporation and later elected to be classified as a partnership, the election would be treated as a complete liquidation of the corporation and a formation of a new partnership. Thus, a final return for the corporation and a firstyear return for the partnership each would have to be filed. In addition, the new partnership would have to ensure that its allocations were in compliance with section 704(b) and the regulations thereunder.”

On December 17, 1996, the Treasury issued the totally revised entity classification regulations, the check-the-box rules.54 The preamble stated: “One commentator asked for guidance on the treatment of conversions by election from partnership to corporation and from corporation to partnership. This issue is outside the scope of these classification rules and thus is not addressed in these regulations. Treasury and the IRS, however, are actively considering issuing guidance on the treatment of such conversions.”

On October 28, 1997,the Treasury proposed amendments to the check-the-box regulations.55 The proposal stated:“In each case, the characterization provided in the proposed regulations attempts to minimize the tax consequences of the change in classification and achieve administrative simplicity. The proposed regulations provide that if an association elects to be classified as a partnership, the association is deemed to liquidate by distributing its assets and liabilities to its shareholders. Then, the shareholders are deemed to contribute all of the distributed assets and liabilities to the partnership. This characterization of an elective change from an association to a partnership is consistent with Rev. Rul. 63-107 (1963-1 C.B. 71).…The proposed regulations also provide that the tax treatment of an elective change in classification is determined under all relevant provisions of the Internal Revenue Code and general principles of tax law, including the step transaction doctrine. This provision in the proposed regulations is intended to ensure that the tax consequences of an elective change will be identical to the consequences that would have occurred if the taxpayer had actually taken the steps described in the proposed regulations.”(Emphasis added.)

On November 26, 1999, the Treasury issued the regulations proposed in 1997 as permanent. It did not discuss corporate debt to the shareholder. It did, however, cite again Rev. Rul. 63-107.

The Curious H.K. Porter Rule

When an insolvent subsidiary like the one in the GLAM is dissolved, no net value is distributed with respect to any stock. If the debt is not paid off but is “otherwise provided for,” the shareholders receive record title to property, a real-life event that must be accounted for by the tax law. If some of sections 331-337 could be applied to such a corporate liquidation, then several of the questions addressed in the GLAM would have answers in the Code, or at least official places to look for answers. The refusal to apply those sections is based on the government’s view that the shareholder’s receipt of “property” means net property value, rather than a real life receipt of property.

This refusal is just nuts. The income tax law was written to apply to real-life events. When shareholders of a corporation receive ownership by legal distribution of property because the corporation dissolved, a Code section labeled distributions in liquidations ought to apply. The decision not to apply those code sections is driven by a peculiar rule attributable to one unreviewed, unappealed Tax Court opinion, H.K. Porter,[58] which did involve some distribution on stock, just not on all stock. The Porter decision ruled that when a parent causes the liquidation of a subsidiary and the parent receives some distribution with respect to its preferred stock but none with respect to its common stock, section 332 does not apply even to the preferred stock for assets exchange, and section 331 applies to that exchange permitting a capital loss, and section 165 applies to the loss on the common, usually permitting an ordinary loss.[59] So the practical effect of the Porter rule is to accelerate loss recognition and potentially convert at least part of the loss into ordinary loss.

The Porter rule has been interpreted to allow the preferred stock loss under section 331, even though section 332 does not apply. In effect, the Porter rule says that a section 331 “complete liquidation” occurs as to the preferred even though the shareholder deducts the loss on the worthless common under section 165, but a section 332 “complete liquidation” does not occur as to the preferred.

How can “complete liquidation” mean different things for purposes of these two statutes, which use the same term? The explanation is attributed to section 332(b)(2): “…in complete cancellation or redemption of all its stock ….”(Emphasis added.) Those words do not appear in section 331. Similar words do appear, however, in section 346, which is applicable to all of subchapter C: For purposes of this subchapter, a distribution shall be treated as in complete liquidation of a corporation if the distribution is one of a series of distributions in redemption of all of the stock of the corporation pursuant to a plan. (Emphasis added.)

Therefore, the normal meaning of redemption would apply and would look to the event as it occurs under local corporate law, which treats a liquidating redemption as the reacquisition by a corporation of its stock in exchange for whatever the corporation has to exchange, which may be nothing of net value.[60]

Because the IRS recognizes that section 331 applies to the preferred in the subsidiary liquidation cases, it can claim that section 332 does not apply to the preferred only by contending that complete redemption “of all” of the stock means different things in the two sections, even though section 346 applies to both of them. This is untenable. It would be obvious to anyone but a tax lawyer that the Code means to describe the complete end of a corporation, not to parse between liquidation of more or less wealthy corporations where the shareholder actually receives property ownership in each case.

So far this odd reading of “all of the stock”has not been undertaken by any appellate court. What is needed is for a shareholder that wants section 332 to apply to the preferred to take the case up and see what a higher court thinks about Porter (which has not been cited by any appellate court).

But when the liquidating corporation distributes to shareholders ownership of property that does not have net value, the IRS asserts that neither section 331 nor section 332 can apply, as stated in Rev. Rul. 2003-125 and the GLAM. As shown, the way to this conclusion was prepared by Porter.

In brief, the path out of the Porter confusion is to recognize the difference between (1) a taxpayer’s disposition of property subject to debt in excess of value, (2) another taxpayer’s disposition of property that similarly is worthless, but not on account of debt in excess of value but rather on account of the property being an ownership interest in an entity that itself is underwater, and (3) the same as (2) but the taxpayer does not even receive under water property. In case (3),the taxpayer simply has worthless property subject to a section 165 deduction and no section 1001 exchange has occurred. In case (1), even if the taxpayer receives in exchange other property that is similarly under water, the taxpayer determines its section 1001 results for its property disposition solely by reference to the liability from which it is discharged; its property acquisition is in effect a separate event.

In contrast, in case (2),when the worthless property not subject to a liability is exchanged for other worthless property that is subject to a liability, the section 1001 analysis cannot be based on debt relief and must be based on the receipt of property in a section 1001 (or section 331) exchange, but for purposes of section 1001 the value received is zero. Then the acquisition of the property burdened by debt produces a section 1012 (or section 334 (a)) basis attributable to that liability assumed.

Conclusion

The GLAM does not simply misinterpret the regulation; it is just wrong. It is wrong because it denies a bad debt deduction that would be allowed in “real life” if the liquidation had actually occurred, with no valid excuse for deviating from that treatment. Maybe taxpayers will not care. Maybe they will maneuver into single parent shareholder status and claim the bad debt loss. But if they cannot do that, then, they should contest the GLAM if it is applied to them, after evaluating the consequences of the alternative.

Jack Cummings is Counsel in the Raleigh, North Carolina, office of Alston & Bird LLP. He received his A.B. degree from Duke University, J.D. degree from Yale University, and an LL.M. degree in Taxation from New York University. He formerly served as Associate Chief Counsel (Corporate) of the Internal Revenue Service. He has litigated both federal and state tax cases, led the Corporate Tax Committee of the ABA Section of Taxation, published a book on the federal tax jurisprudence of the Supreme Court of the United States, written numerous articles, and taught corporate taxation at several law schools, including New York University. His email address is jack.cummings@alston.com.

1. See Elliott, Practitioners Troubled by “Schizophrenic” Memo Involving Worthless Partnership, 2011 TNT 207-2 (Oct. 26, 2011). See also Tobin, IRS GLAM on Liquidation of Insolvent Foreign Sub, BNA Interna tiona l Journa l (Nov. 2, 2011) (pointing out that if section 332 had applied a basis step-down would have been required); Deanna Harris, CAA AM 2011-003: Many Issues, Not Many (Satisfactory) Answers, J. Corp. Taxation (2012).2. The creditor’s treatment of the exchange of a debt claim for a partial payment as a worthless debt deduction for the unpaid portion, as contrasted with a section 1271 exchange, has been questioned. See Potter, Revisiting Check and Sell Transactions, 115 Tax Notes 1277 (June 25, 2007); Kleigman & Turkenich, Debt Losses: Timing and Character Issues Revisited, 111 Journa l of Taxation (July 2009). The correct answer, however, is that (1) a section 166 bad debt deduction is appropriate when the debt remains outstanding but is not further collectible, either immediately after a final partial payment or separate and apart from any partial payment, because remaining outstanding but being uncollectible is the correct definition of “worthlessness” of a debt obligation; (2) that section 165 loss deductions can occur either when the creditor sustains a loss because (a) the definition of worthlessness is satisfied, or (b) the creditor effects a section 1001 disposition of the debt obligation; and (3) that in case of overlap — i.e., when the debt remains outstanding and worthless and the creditor has sustained a loss — section 166 trumps because it is the more specific rule, except when section 166 itself defers to section 65, which section 166(e) does by excluding all worthless security debt from section 166. Cummings, Bad Debt or Loss?, 123 Tax Notes 111 (Apr. 6, 2009).3. Crane v. Commissioner, 331 U.S. 1 (1947); Commissioner v. Tufts, 461 U.S. 300 (1983).4. This may not be possible under the law of some foreign jurisdictions. Getting rid of a minority member just before checking the box would be sort of a reverse Granite Trust ploy. Granite Trust Co. v. United States, 238 F. 2d 670 (1st Cir. 1956) (majority shareholder may have minority redeemed in order to maneuver into section 332 liquidation of a subsidiary). But see Fiduciary International Currency Advisor A Fund, LLC v. United States, 747 F.Supp.2d 49 (D. Mass. 2010) (casting doubt on the continued viability of the Granite Trust approach, under the economic substance doctrine).5. T.D. 8844 (Nov. 29, 1999).6. Section 752(c) limits the effect of the liability to value of the property. The GLAM seemingly assumes the property is security for the property, but it never says that explicitly. Also, the GLAM appears to assume that Treas. Reg. § 1.752-1(e) does not restrict the value limitation to the inbound assumption reduction, even though it seems to say so; the GLAM’s approach makes for nice symmetry, but the regulation speaks only of the transferee of property, which X is not.7. The GLAM does not treat the $110 as a Treas. Reg. § 1.752-7 liability (i.e., an obligation that is not a liability), but rather as a Treas. Reg. § 1.752-1(a)(4) liability. That means the liability assumption must have created basis in any of the obligor’s assets when the obligor incurred the liability. Although it is not clear from Treas. Reg. § 1.752-1(a)(4) what taxpayer must have so obtained basis upon incurring the debt, an example in a different regulation shows that the relevant taxpayer is the partner, when the liability is one that the partnership assumes from the partner. Treas. Reg. § 1.752-7(b)(3)(iii).8. See Treas. Reg. §1.1001-2 (a)(4)(iv) (“Contributions and distributions of property between a partner and a partnership are not sales or other dispositions of property”). Contrast the concern with under water entity creation in the corporate area. See Cummings, New Prop. Regs. Change Rules for Transactions Where Property or Stock Lacks Net Value, 103 Journal of Taxation 14 (July 2005).9. The first alternate construct (discussed in the text that follows) does assume that the creditor was not paid because the payment was otherwise “provided for.” The GLAM, however, does not apply that construct.10. If Z corporation sold its asset for $100, recognized a $20 loss it could not use, and paid all $100 to X, it would not recognize any taxable cancelation of indebtedness income because relief from the remaining $10 of debt did not make Z solvent. X would sustain a tax loss of $110, reflecting loss of all of its equity and $10 of its loan, which matches X’s economic loss.11. Treas. Reg. § 1.752-1(e) is narrower than section 752(c) and does not apply the fair market value limit when the partnership liability is reduced as a result of a sale rather than a distribution. Alternately, you could say the section 752(c) limit applied, the outside basis was reduced to $10 and the partnership’s $10 loss passed through, reducing the outside basis to zero. That would double up the remaining loss allowed, however, from the right amount, $10, to $20.12. I.R.C. § 108(d)(6).13. State corporate statutes usually require that the liquidating corporation pay or provide for the payment of its liabilities; directors generally are liable if the corporation fails to do this.14. Treas. Reg. § 1.1001-3(e)(4)(i)(c).15. Treas. Reg. § 301.7701-3(g)(1)(ii).16. Section 752 causes assumption of liabilities to create deemed distributions and contributions that have basis effects. Treas. Reg. § 1.752-1(a)(4) defines a liability as one that adds to property basis or creates a deduction. Obligations that are not liabilities as defined are governed by Treas. Reg. § 1.752-7, referred to as Treas. Reg. § 1.752-7 liabilities. Although the latter regulation is very difficult to understand upon first (or later) reading, its purpose is shown by the base case for which it was written: property in respect of which an unpaid environmental remediation liability was incurred after the current owner bought the property. That sort of contingent liability did not enter into the basis of the property when bought by the current owner or later, and no deductible payment has been made. When the current owner transfers the property to a partnership, that obligation will not be treated as a liability for section 752 purposes and so its assumption by the partnership does not reduce the transferor’s basis in its partnership interest and the partners do not get basis by being deemed to assume it. If later events make the obligation payable in some amount then that amount can enter into the section 752 calculations. Because that never happens in the cases posited here, hopefully the effects of a Treas. Reg. § 1.752-7 liability can be ignored (after eliminating it from the section 752 analysis).17. See Bittker & Lokken, Federal Taxation of Income, Estates and Gifts ¶ 41.2.2.18. X could obtain all of the Z interests and then transfer 20% to Y, but that would be treated as if X transferred 20 percent of the property to Y and they jointly capitalized Z.19. Treas. Reg. § 1.707-3(b).20. See Treas. Reg. § 1.704-1(b)(2)(iv)(e)(2) (“Distribution of promissorynotes.”). The capital account analysis is beyond the scope of this article.21. X has a cost basis up to $100. As to the extra $10 distribution, it takes Z’s basis in its own obligation, which is zero. I.R.C. § 732(a)(1). 22. Treas. Reg. § 1.752-1(a)(4).23. Section 707(a) serves the function of section 351(b), but in a very different way. There is no other analog to section 351(b) in subchapter K. The alternative to applying section 707(a) would be to treat the deemed distribution of a partnership note as a section 731 distribution, unrelated to the asset contribution, which is done here as to the $10. A different regime applies to a corporate debt issued upon a section 351 exchange: It is treated as boot in the transaction. See Rev. Rul. 80-228, 1980-2 C.B. 115, rejecting the result in Wham Construction Company, Inc. v. United States, 37 AFTR 2d 76-950 (D.S.C. 1976), aff’d, 600 F.2d 1052 (4th Cir. 1979).24. Then the entire $110 obligation would be a Treas. Reg. § 1.752-7 liability.25. Treas. Reg. § 301.7701-3(g)(1)(ii).26. Cf. Burk-Waggoner Oil Association v. Hopkins, 269 U.S. 110 (1925) (state classification of corporations does not control federal tax classification). See generally, Cummings, The Supreme Court’s Federal Tax Jurisprudence 389, et seq. (2010).27. The regulation’s reference to the “distribution” of a liability is unfortunately loose language that dates only to Rev. Rul. 84-111 and appeared nowhere in the regulations until the check-the-box regulation used the term. Liabilities are not “distributed”; they are assumed, or not assumed; and property may be distributed subject to a liability that is not assumed. But liabilities are not “distributed” because you cannot force a recipient of property to personally assume a liability, except to the extent that the transferee liability rules described in the text apply.28. Cf. I.R.C. § 336(b) (a shareholder may assume a corporate liability incident to a liquidation).29. See Rev. Rul. 72-464, 1972-2 C.B. 214.30. Arthur L. Kniffen v. Commissioner, 39 T.C. 553 (1962), acq., 1965-2 C.B. 5; Rev. Rul. 68-359, 1968-2 C.B. 161.31. See, e.g., Report of Los Angeles County Bar Association, Entity Transformations, BNA Dai ly Tax Report (May 12, 2004).32. REG-105162-97, 62 F.R. 55768-55773 (Oct. 29, 1997).33. See, e.g., Morton Q. Petersen v. Commissioner, TC Memo 1971-21 (Louisiana law limited shareholder’s liability to gross value of assets received). For example, when a corporation liquidates and distributes property to shareholders without paying its federal tax debts, section 6901 provides the procedure by which the IRS can pursue the shareholders who received corporate property to collect the corporate tax debts, but the local law provides the rights against the shareholders, be they equitable or statutory under local law. See Bittker & Lokken, Federal Taxation of Income, Estates and Gifts¶ 111A.10. 34. Bittker & Lokken, Federal Taxation of Income, Estates and Gifts¶ 111A.10.35. “If section 332(a) is applicable to the receipt of the subsidiary’s property in complete liquidation, then no gain or loss shall be recognized to the subsidiary upon the transfer of such properties even though some of the properties are transferred in satisfaction of the subsidiary’s indebtedness to its parent. However, any gain or loss realized by the parent corporation on such satisfaction of indebtedness, shall be recognized to the parent corporation at the time of the liquidation. For example, if the parent corporation purchased its subsidiary’s bonds at a discount and upon liquidation of the subsidiary the parent corporation receives payment for the face amount of such bonds, gain shall be recognized to the parent corporation. Such gain shall be measured by the difference between the cost or other basis of the bonds to the parent and the amount received in payment of the bonds.”Treas. Reg. §1.332-7 (1955).36. See also Rev. Rul. 68-602, 1968-2 C.B. 135.37. The wisdom of the Spaulding Bakeries/H.K. Porter theory is discussed in the text that follows.38. See also Houston Natural Gas Corp. v. Commissioner, 9 T.C. 570 (1947), aff’d, 173 F.2d 461 (5th Cir. 1949).39. O.D. Bratton v. Commissioner, 31 T.C. 891 (1959), aff’d, 283 F.2d 257 (6th Cir. 1960) , cert. denied, 366 US 911 (1961) (acq. and nonacq.). 40. Cf. LTR 200114029 and similar rulings that chose not to treat corporations as liquidating when they lose their corporate charters, even after the check-the-box regulations were adopted. See Bragonje, The Rise and Fall of the Check-the-Box Regime: A Solution to Recent Private Letter Rulings’ Troubling Use of the De Facto Corporation Doctrine, 2005 TNT 87-45 (May 6, 2005).41. T.D. 6503, 25 Fed. Reg. 10,928 (1960) (essentially writing the Morrissey factors into the regulation, with a majority of factors being required to escape corporate classification).42. The results in the second and third cases evidently precluded entity debt from altering the partners’ basis in the partnership interests, contrary to section 752.43. See GCM 33507 (May 11, 1967) (“The revenue ruling was intended to avoid an inequity to the shareholders and was prompted by a memorandum from Mr. Jay W. Glassmann, then Tax Legislative Counsel. We believe that similar equitable consideration should prevent an individual from claiming capital gains treatment solely because of a technical reclassification.”); GCM 33608 (September 1, 1967) (“The Service has seemingly indicated a policy against attaching damaging tax consequences to an involuntary change in the tax classification of a professional service organization which is occasioned by the Service’s changing or clarifying its regulations. This policy was first expressed in Rev. Rul. 63-107, C.B. 1963-1, 71. This ruling provides that where a professional service organization’s reclassification as a partnership is involuntary and comes about solely by operation of a change in the regulations, there is no voluntary liquidation by the taxpayer and no tax consequences by way of a constructive liquidation should arise from this involuntary reclassification. The Service reiterated this policy against attaching damaging tax consequences to an involuntary reclassification in Rev. Proc. 65-27, C. B. 1965-2, 1017.”). See also Knickerbocker, The Logical Difficulties of Let’s Pretend Tax Law, 9 Villanova L. Rev. 3, 8 (1964) (explaining the ruling as based intentionally on the fact that the change in characterization was forced on the taxpayer by the Treasury); New York State Bar Association, Report on Check the Box Regulations, 96 TNT 169-22 (Aug. 23, 1996) (identifying the ruling as requiring taxable liquidation treatment).44. See, e.g., LTR 9252033; LTR 9401014; LTR 9610030; LTR 9618003; TAM 9618003 (conversion to partnership taxable where not caused by change of regulations).45. See generally Nocjar, Closely Held Companies: Now Might Not Be the Best Time to Convert to Tax Partnership Status, 111 Journal of Taxation 220 (Oct. 2009); Banoff, Mr. Popell Gets Reel about Conversions of Legal Entities: The Pocket Fisherman Flycasts for Form by Snags on Substance, 75 Taxes 906 (1997).46. Even the continuation of accrual of interest by a debtor that cannot pay does not prevent the IRS from treating what had been debt as equity. See Cuyuna Realty Co. v. United States, 382 F.2d 298 (Ct. Cl. 1967). 47. Cf. GCM 39158 (Mar. 1, 1984). This GCM approved Rev. Rul. 70-489, 1970-2 C.B. 53, stating that there was no reason the continued operation of the business of a liquidated debtor subsidiary should preclude the parent/creditor’s stock and debt loss deductions, and that a 1941 Tax Court decision had so ruled. LTR 8008001, however, involved a foreign subsidiary of a domestic parent. The subsidiary was losing money and the parent was advancing money to protect its reputation. Before selling the subsidiary in 1975 the parent evidently claimed a worthless stock loss in 1974. The LTR denied the stock loss because of the ongoing business of the subsidiary, despite the excess of liabilities over value of assets. See also FSA 200226004, discussed in the next footnote, which disputed the insolvency.48. FSA 200226004, issued by IT&A, involved a U.S. group with two foreign subsidiaries, one of which assembled products for sale to the other, which the other sold in a particular foreign country. The U.S. group checked the box on the foreign subsidiaries, causing them to be treated for U.S. tax purposes as liquidating and reforming as partnerships (two members of the group shared ownership of the stock). The subsidiaries continued to operate as before and continued to be treated as corporations under the foreign country’s law. The U.S. group claimed a section 165(g) loss on the stock of the subsidiaries as a result of checking the box. Under Treas. Reg. § 301.7701-3(g)(3), the subsidiaries were deemed to liquidate the day before the effective date of the election, which was the last day of the year in which the group claimed the stock loss.The group evidently did not write off the subsidiaries’ corporate equity on the group’s accounting books. The FSA concluded that the taxpayer had failed to show worthlessness of the stock for several reasons: (1) the facts did not show that the liabilities so outweighed the asset value, including potential, ongoing concern, value, in order to prove that the subsidiaries did not have value and thus were insolvent so that section 332 could not apply; evidently this factual uncertainty was based in part on uncertainty about whether debt of the subsidiaries held by the U.S. group was true debt; (2) the alternative indicator of worthlessness was not shown by checking the box because that was not by itself an “identifiable event” evidencing worthlessness; in contrast, an actual liquidating sell-off of all assets effectively terminates any potential intangible value of an ongoing business; and (3) the case is unlike Rev. Rul. 70-489, 1970-2 C.B. 53, because that ruling assumed as a fact that the stock of an actually liquidated subsidiary was worthless, despite the continuation of the subsidiary’s business as a branch of parent, and despite the existence of subsidiary debt owned by parent (which the ruling treated as real debt), whereas here worthlessness has not been shown. The FSA obviously could not stand because (1) it implied that an ongoing business could not be insolvent, and (2) a check-the-box liquidation would not be treated as a “real” liquidation for some purposes. The former is just wrong and the latter flies in the face of the almost total (see exceptions for I.D. numbers and the like) insistence of the Treasury and IRS that check-the-box liquidations are “real”; indeed, the only way the Treasury persuaded itself to issue the check-the-box regulations in the first place was to convince itself that taxpayers could get to the same placed longhand. Rev. Rul. 2003-125, 2003-2 C.B. 1243, confirmed that it was possible for a check the box liquidation to produce a section 165 recognized loss on subsidiary stock if section 332 does not apply, after valuing all of the corporate assets, including intangible going concern value, even if the insolvency is caused by debt to the parent and the business of the subsidiary continues. Thus, the ruling pushed back on the reluctance reflected in the FSA to put a number on the potential value (sometimes called “option value”) of the subsidiary’s business, and to treat the check-the-box liquidation as real. The ruling “superseded” Rev. Rul. 70-489, but did not disagree with its conclusions. The following letter rulings have been issued in reliance on the revenue ruling: LTRs 200710004, 201011003, and 201115001.49. CCA 200706011 showed the field raising the same arguments addressed in the earlier guidance and the advice repeated the same explanations why the debt would most likely be recharacterized as preferred stock and so section 332 would still not apply. The advice, however, was not particularly supportive of treating debt as preferred stock because the debt was documented and serviced as debt. Of course, a bad debt deduction for the parent under section 166(a) produces ordinary loss, a better result than a capital loss upon partial satisfaction of the recharacterized preferred stock.The GLAM reflects a rethinking of the 2007 CCA: While it does not reject the possibility of recharacterizing the debt to the parent as equity, it throws cold water on in by stating that the debt was genuine debt when incurred, which Z expected to repay in full. This implies that once debt, always debt (which may or may not be the law, but will not be pursued here). See, e.g.,Alterman Foods, Inc. v. United States, 505 F.2d 873 (5th Cir. 1974); Peoplefeeders Inc. v. Commissioner, TC Memo 1999-36.50. Evidently issued without knowledge of Rev. Rul. 2003-125, 2003 C.B. 1243, which had been issued one week earlier, Area Counsel, LMSB (Financial Services) issued Memorandum 20040301F. It advised a team manager that, even if the nominal debt held by a parent corporation (and relied on to render a foreign subsidiary insolvent when it checked the box to “liquidate”) were treated as equity, it would be preferred stock. As a result, section 332 still would not apply to the liquidation if the parent did not receive a distribution of property on the common stock, and so the parent could claim a loss for the worthlessness of the common stock under section 165. The memorandum focused on the possibility of recharacterizing the debt to the parent as preferred equity. It stated: “Therefore, reclassifying intercompany debt as preferred stock has the result of converting an ordinary loss [under section 166] into a capital loss with respect to the investment in the preferred stock (reclassified debt) not recouped in the liquidation.” Section 165(g)(3)’s allowing an ordinary loss would not apply to a partial payment on the preferred that used to be debt because it was not wholly worthless.51. LTR 9425024 (replacing LTR 9403010) and LTR 9610030 (issued by IT&A) involved facts basically the same as the GLAM. The ruling allowed the bad debt loss recognition and caveated the application of section 721 to the creation of the partnership.52. See also LTR 9401014 (treated as section 331 liquidation and formation of partnership).53. Notice 95-14, 1995-1 C.B. 297. The regulation process was supervised by PSI.54. T.D. 8697 (Dec. 17, 1996).55. REG-105162-97; 62 Fed. Reg. 55768-55773 (Oct. 28, 1997).56. T.D. 8844.The proposed association to partnership section was adopted unchanged. The preamble states: “The proposed regulations provide that an elective conversion of an association to a partnership is deemed to have the following form: The association distributes all of its assets and liabilities to its shareholders in liquidation of the association, and immediately thereafter, the shareholders contribute all of the distributed assets and liabilities to a newly formed partnership.…A commentator suggested that the proposed form for an elective conversion of an association to a partnership may not minimize the tax consequences of such a conversion under certain circumstances. The commentator suggested that the proposed form should be available as an election, but that the default form should be a deemed transfer of assets and liabilities from the electing corporation to a newly formed partnership for interests in the partnership followed immediately by a liquidation of the electing corporation.…The IRS and Treasury believe that under current law a voluntary formless change from an association to a partnership should be treated as a liquidation of the corporation followed by a contribution of assets to the partnership. See Rev. Rul. 63-107 (1963-2 C.B. 71). Moreover, if the assets were deemed contributed by the electing corporation to the partnership for partnership interests followed by a liquidation of the corporation, the application of section 704(c) (contribution of appreciated property), section 708 (partnership termination), and section 754 (elective adjustments to the basis of partnership assets) could be somewhat complex and difficult for taxpayers and the IRS to administer. Therefore, the proposed form for the elective conversion of an association to a partnership is adopted without change.”57. Id.58. H.K. Porter Co., Inc. v. Commissioner, 87 T.C. 689 (1986). See generally Cummings, New Proposed Regs. Change Rules for Transactions Where Property or Stock Lacks Net Value, 103 Journal of Taxation 14 (July 2005) (the earlier decision in Commissioner v. Spaulding Bakeries, Inc., 252 F.2d 693 (2d Cir. 1958) did not create the problem).59. Porter managed not to identify whether sections 331 or 1001 applied to the exchange of the preferred, citing only section 165(a), but the IRS has closed the loop, stating that section 331 applies to the preferred. LAFA 20040301F; CCA 200706011.60. The definition of redemption in section 317 does not apply to the use of the word in section 346.